Remarks by Jeremy Rudin Superintendent of Financial Institutions to The International Finance Club of Montréal, Quebec, March 17, 2015

International Activities: How Canada Plays its Part

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International agreements on minimum prudential standards, in our view, are the best way to implement prudential standards for our globally-active financial institutions without impeding their ability to compete with foreign institutions.

Good afternoon, ladies and gentlemen. Before I begin, I would like to thank Luc St-Arnaud and the International Finance Club of Montréal for organizing this event.

This is my first speech in Montréal as Canada’s Superintendent of Financial Institutions, and I am especially pleased to be here with you.

I would like to greet my colleague, Louis Morisset, of the Autorité des marchés financiers (AMF). I wish to also greet Brigitte Phaneuf, the managing director here at our Montreal office. The office plays a key role, as it supervises 60 federal financial institutions, including 18 deposit-taking institutions, 33 life and property and casualty insurance companies and branches, and 9 representative offices.

Montréal is a city I much enjoy, not only because it is my home town, but also for its vibrancy, innovation, vitality and diversity, especially with regard to its financial sector. Indeed, it is here that the first Canadian bank was founded in 1817.

Almost 200 years later, we find ourselves in a much different setting with many more institutions competing in the marketplace, firms that offer a vast array of products and services.

Given the mission of the Club, I will speak to you today about current international issues in the regulation and supervision of financial institutions.

The issues that will be debated and decided in the coming months will affect most institutions, whether or not they are regulated by OSFI. They will also have an impact on Canadian markets and investors.

What are the advantages of international agreements?

Canada has been, and will continue to be, a strong supporter of international agreements on prudential regulatory standards in the financial sector. OSFI has put forth, and will continue to expend considerable effort to ensure that these agreements are well adapted to the Canadian financial system.   

International agreements on minimum prudential standards, in our view, are the best way to implement prudential standards for our globally-active financial institutions without impeding their ability to compete with foreign institutions.

That alone is a compelling reason for Canada to honour these agreements and to be seen as doing so.

Moreover, in this post-crisis world, the Canadian financial system’s widely acknowledged reputation for rigorous regulation has become a competitive advantage for our financial institutions, as it helps them to maintain an excellent reputation around the world.

What is OSFI’s approach to discussing and negotiating international standards?

When it comes to revising or developing new international standards, our primary objective is to seek consensus on the means to strengthen the stability of the global financial system.

However, whether the negotiations involve new or revised standards, the end result must be beneficial for Canada and must work for the Canadian financial sector.

Canada’s relative success before, during and after the crisis has given us greater influence internationally than the size of our economy would suggest. Of course, international negotiations require some compromise - we cannot have it all.

Bank capital requirements have been continually improving

Since the last financial crisis, prudential supervisors in the global banking sector have put much effort into developing international rules. 2015 will be yet another busy year.

The financial crisis primarily taught us the importance of having enough quality capital to absorb severe but plausible losses.

As you know, the Basel Committee on Banking Supervision is the organization that is charged with setting international standards for banking regulation.

The first round of post-crisis reforms, undertaken by the Basel Committee, focused on increasing the quality and quantity of capital. It resulted in the agreement commonly referred to as Basel III.

The current objective of the Basel Committee is to improve Basel III.

The committee’s work plan will touch on the two methods that banks can use to determine their capital requirements, the standard approach and the more complicated internal ratings–based (IRB) approach.

Let us start by looking at the standardized approach.

The Basel Committee is seeking to:

  • reduce reliance of this approach to calculating bank capital on external credit rating agencies;
  • enhance comparability of bank capital requirements across banks; and
  • strengthen the links between the standardized approach and the internal ratings–based (IRB) approach.

The outcome of this work will affect most banks.

As I stated earlier, we want to ensure that the regime determined by these deliberations will be suitable to Canada’s financial system.

For example, the portfolios of most banks in Canada contain a large proportion of residential mortgages.

The Canadian residential mortgage market is unique, as banks are only exposed to mortgages with down payments of 20 per cent or more. Lenders are protected against default on the other, low down-payment mortgages, through government-backed insurance.

We need the standard to accommodate this structure, even though it is unique to Canada, so that we do not inadvertently incent our smaller banks to take on riskier mortgages.

The importance of internal risk measurement models

Now let us turn to the second method available to banks for setting their capital requirements, the internal ratings–based (IRB) approach.

Internal models for measuring risk play an important role in determining the level of capital required by large banks.

The relevance of using such models is currently the subject of lively debate among academics, supervisors and financial institutions.

At OSFI, we constantly reinforce that it is the banks themselves that determine the risks they want to assume, risks they must subsequently measure, monitor and manage.

Internal risk measurement models can be very helpful in that regard, especially for large banks that have the data and the resources to develop and maintain models.

OSFI favours the internal ratings based approach, in part because it provides a strong incentive for banks to invest the resources necessary to keep their risk models accurate and up to date.

One of the issues with the use of internal risk measurement models is the wide range of risk weightings across jurisdictions.

The wider the range of such weightings, the less confidence the international community may have in the use of models.

As mentioned earlier, one of the main benefits of having an international agreement like Basel is that it helps create a level playing field across countries.

The wide variation in risk weightings that we observe across banks suggests that we are not getting the full benefit when it comes to internal models.

So we are supportive of efforts to reduce unjustifiable differences in risk weights.

Moreover, to be of use, models require good data.

We must recognize that, depending on the circumstances, it is sometimes difficult to collect the data that would make it possible to model severe but plausible losses.

This reality has special significance in Canada, where we were able to avoid the traumatic events that took place in other countries.

However, we must not think that negative events will not occur in Canada simply because they have not in the past.

Therefore, we are prepared to consider new restrictions on the use of models when the data on severe losses are limited. For instance, we must be wary of modelling certain types of risk, such as in the areas of sovereign debt and AAA-rated corporations.

Usefulness of leverage ratios and stress tests

One way to minimize the risk associated with complex internal risk measurement models is to use an unweighted measure. Such a limit is quite simple as it treats all assets the same way.

For many years in Canada, we have had an assets-to-capital ratio in addition to the regulatory capital ratio, to limit balance sheet size relative to capital available.

This was of great help to us in the last financial crisis.

The domestic assets-to-capital ratio will soon be replaced by a leverage ratio based on a method agreed upon by the Basel Committee.

The question internationally is where to apply the minimum permissible simple leverage ratio.

Our view is that the rules on capital requirements should be based primarily on risk; however, we must be aware of the limitations of risk-measuring methods.

To best play its role, we believe that the simple leverage ratio should be constraining, but only from time to time. So, we will be seeking to set the international standard at a level that accomplishes this.

While some view the leverage ratio as the solution to the internal models approach, others see stress testing as the solution.    

At OSFI, we see great value in stress tests because they help senior management to measure and understand the risks facing their banks and the financial system.

Test results also help us to determine whether capital requirements are adequate.

However, we have yet to conduct a “public common stress test,” which some other countries have recently done, for the following reasons:

  • every bank has different exposures, so a single scenario does not provide a comparable test;
  • any bank needs to be ready for a variety of negative scenarios, not just one;
  • this would inject a public relations element into the exercise, both for the banks and for the regulator, which could reduce its value as a risk management tool.

Which other international measures may affect Canada’s financial system?

Other international measures for additional loss-absorbing capacity may affect Canada.

The Financial Stability Board (FSB) is discussing the details of a new requirement for Global Systemically Important Banks (G-SIBs) that goes beyond the existing capital requirements. This new measure, Total Loss Absorbing Capacity (TLAC), will reduce the scope and impact of G-SIB failures by improving global resolution frameworks.

This will give such banks the loss-absorbing and recapitalization capacity to continue their activities without requiring government support or threatening financial system stability.

Such an approach is currently being developed for Canada’s large banks. Since legislative amendments will be required, the Minister of Finance is leading the initiative with input from federal agencies, including OSFI.

What about international insurance capital requirements?

What I have been discussing regarding the banking sector amounts to adjustments to a longstanding approach to capital. On the international insurance side, however, we are basically starting from scratch.

Last year the International Association of Insurance Supervisors (IAIS) developed a “basic” standard, the first time that insurance regulators have come to an agreement on a common quantitative capital assessment tool.

The IAIS is now preparing to develop a global solvability standard for internationally active insurance companies. We applaud its efforts.

This measure will enable us to better compare our capital requirements for insurance companies with those of other jurisdictions.

Another important element that the IAIS is looking at is the quality of regulatory capital.

In our view, regulatory capital should consist only of instruments that can be relied upon, that are truly loss-absorbing and that will ensure business continuity during a period of stress.

The capital regime’s treatment of assets also matters for Canada’s aging population and the Canadian economy. Some of Canada’s life insurance company portfolios contain a large proportion of long-term products backed by a wide range of actively managed investments.

OSFI believes that it is important that for regulatory capital purposes, companies’ policyholder obligations continue to be valued in a way that is not unduly volatile.

Otherwise, companies may find themselves under pressure to stop offering longer-term insurance and wealth management products.

In other words, the capital regime needs to protect policyholders while allowing insurance companies to choose what products to offer.

While international work is progressing, we at OSFI are taking the opportunity to update our own capital frameworks. Our work includes:

  • developing frameworks for property and casualty companies;
  • designing a new capital test for mortgage insurance companies; and
  • updating the capital framework for life insurance companies.Footnote 1

Of course, we will closely monitor development of the international capital standard, and assess whether our own capital tests should be adjusted.

Co-operating with international regulators

Developing international rules is definitely important, but co-operation among supervisors involves much more than that.

It is essential to engage in dialogue with international supervisory bodies for two reasons:

  • First, a number of Canadian financial institutions have operations around the world and must therefore meet the requirements of various supervisory bodies.
  • Second, this enables us to better understand the interconnectivity of the components of the global financial system. 

In fact, monitoring and evaluating system-wide risks is part of OSFI’s statutory mandate.

We must be mindful of what is going on in the various parts of the system, including the prudentially unregulated components that facilitate financing the real economy, such as commodity trading, hedge funds or a revived securitization market.

Although this shadow financial system seems more present in countries other than Canada, we must consider the potential impact of shadow banking on the sector regulated by OSFI and the potential impact of our actions on shadow banking.

The global financial crisis we experienced is often described as a banking crisis, and indeed it was.

However, a number of triggers came from outside the banking system, in securities markets.

Under these circumstances, the importance of maintaining a dialogue between prudential supervisors and securities regulators is clear. At the international level, the Financial Stability Board has already taken some steps in this direction, but in my view, more can and should be done.

The need to maintain dialogue among domestic regulators

Cooperation among domestic regulators is just as important as international relations.

Canadian regulatory bodies have numerous forums in which to share information and discuss issues and actions involving financial institutions.

For example, there is the Financial Institutions Supervisory Committee (FISC), a statutory committee I chair, which is composed of representatives from federal organizations including the Canada Deposit Insurance Corporation, the Financial Consumer Agency of Canada, the Bank of Canada, the Department of Finance Canada, and OSFI.

Another committee that I would like to mention, on which I sit, is the Heads of Regulatory Agencies Committee (HOA), a committee chaired by the Governor of the Bank of Canada, which brings together some federal oversight bodies as well as  supervisors of the major securities commissions such as the AMF.

The mandate of the HOA is to help its members gain a better understanding of markets and their regulation, such as over-the-counter derivatives and the Canadian Dollar Offered Rate. I am convinced that we can profit even more from these discussions in the future.

We are also maintaining dialogues with our provincial counterparts by participating in the Canadian Council of Insurance Regulators, the Canadian Association of Pension Supervisory Authorities, and the Credit Union Prudential Supervisors Association.

I also want to tell you how much we value establishing and maintaining bilateral relationships with other regulators in Canada.

For instance, I am thinking of the Autorité des marchés financiers (AMF), which supervises the Desjardins Group and the Montreal Exchange, two of Canada’s larger financial institutions.

We have had good discussions with our colleagues at the AMF, and I plan to create more opportunities for deeper discussions on issues that concern us as regulators.

Conclusion

Before I finish, I would like to emphasize three points:

First: OSFI will continue to work with our foreign counterparts to ensure that international banking regulatory standards remain fundamentally risk-based and suitable to the Canadian system.

Second: OSFI welcomes the new international capital framework for insurance companies. This will facilitate international comparisons of insurance company capital and, we hope, eventually lead to a level playing field for all.

Third: OSFI will continue to participate in discussions with our counterparts, both internationally and domestically. We firmly believe in the need to exchange views because we have a lot to learn from each other. This, in the long run, will strengthen Canada’s financial system.

I thank you for your attention.

Footnotes

Footnote 1

Policy paper on Life Insurance Capital Framework Standard Approach, (January, 2015). This paper can be found at the following link: http://www.osfi-bsif.gc.ca/Eng/fi-if/ic-sa/lf-sav/Pages/LISFSA.aspx

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